Tax Tip 89: Borrowing and onlending Interest Free to a Discretionary Trust

That could be good for income in the immediate future but also consider capital gains down the track

 

Thats what I was thinking too. Losses in a trust arent much value if the activity ceases. And may even force a family trust election.

Simplicity is sometimes a practical startegy

Just make sure the loan is both documented and also maintained. Using a loan agreement drafted by a solicitor. If your wife is a co-borrower that requirement might even be avoided BUT do ensure that the pathway between borrowing and use is to her Commsec account for example

 

Idea being income for life - no intention of selling, continue to build up. Use income to paydown OO debt.

Ideally shouldn't be losses in the trust, borrowing @ circa 4% ideally returning more than this.

Previous loan agreement wasn't drawn up by lawyer, but was witnessed by a JP. Any thoughts about that being a issue?
Wife isn't a co-borrower, so looks like stating need to ensure active repayments not just something like *interest repayment with final loan repayment* and keeping track of interest accumulated....
Would need to be having active repayments... thoughts on capitalised interest in this scenario.
Eg: Wife borrowing $100k from me $90k invested into shares $10k kept for repayments of the loan.
Guessing might have impact if then share dividends aren't used to reduce the loan and instead used to repay OO
Trying to think of simplest way to have her making the repayments, given her only income will be the shares dividends which are different frequency to a typical loan (maybe have loan agreement alined with the share dividend?) and also case where dividend is < interest repayment

 

Need a proper enforceable loan agreement. I had a client with one drawn up by a lawyer that was rejected in a private ruling. No need for a job witness either

 

CGT losses ? I see that a lot. If a GFC type event occurs markets will correct and render the belief that markets always rise to be false.

You cant borrow $$$ to repay the loan without a loss of some deductibility. I would be seeking tax advice to be honest

An agreement drawn up by yourselves and witnessed (by anyone) may be worth the value of the paper itself. The witnessing applies to the sigantures only. Not what is agreed and the terms. And then there is maintaining the loan differently to what is acceptable and agreed. I dont know. Thats what lawyers do, not tax advisers

 

If you are wanting to debt recycle the capital gains might speed things up too. Or the opposite

 

So drawn up by lawyer but still rejected? Was was the basis for the rejection. How do you ensure was is drawn up is then acceptable and not a waste of time/money?

 

The advice that accompanies such a issue is far more value than the paper itself.

All arrangements can fail due to form or substence. The ATO ask for corroborating docs for many issues eg a loan agreement and a copy of the account that is maintained, trustee resolutions, evidence of funds advanced that are the basis for the agreement and the support for the use of the borrowed funds being a deductible outgoing.

Having a loan agreement alone doesnt mean much

 

This one was too vague. Uncommercial terms that no one lending to a stranger would lend on. It was still a valid loan though, but the interest was not deductible

 

Often too a loan that accrues interest that never seem to be paid. Some minimum loan repayments perhaps, compounding balances and worst of the lot a loan which was never made. The agreement says it was yet the sum advanced cant be demonstarted as advanced. Or it credits a savings account etc.

 

I have questions relating to above quotes.

Let's say Homer decides to purchase an IP, he takes out an equity loan against his PPOR and gets $150k in a new offset account. He decides he wants to setup a DT with corporate trustee for the IP purchase.

He has a solicitor draw up a loan agreement between himself and the trustee.

1) can the loan agreement be setup in order so that any and all future amounts transferred from the offset to trust account are considered a loan? Or would a separate loan agreement need to be in place for specific amounts?

Just thinking of things like stamp duty and other buying expenses, could they be smaller lump sums transfered to the trust account?

There would be a period of time from when the first expenses are paid by the trust for the IP purchase and the time rental income is generated.

2) how do the loan agreements generally account for this as during that time, the trust would have no income to pay Homer the loan repayments?

3) during this time, can Homer still claim a tax deduction of the bank interest even though he is receiving no income from the trust yet?

 

1. Can be set up like a loc
2. Lend more so the trust has something to pay you back with, or capitalize the loan
3 not without income

 

Regarding point three - There could be a loan agreement which provides for accrual of interest (trustee to Homer) which is accounted for as a capitalised sum on the loan prior to completion so that actual payment commences when the property is completed. However, care must be taken that the matter creates a constructive receipt through the loan terms and the accounting (TR 2018/17) by BOTH the trustee and Homer. But this can also be attacked if the terms are completely non-commercial or the subsequent loan balance isnt made-good with repayments etc. Interest , loans and timing matters are common features to scheme concerns and Part IVA.

A promissory note facility is a good mechanism rather than a straight loan agreement. This mechanism may capitalise. Best that it is also supported by a prevailing loan agreement that governs each note and its rollover, repaymnets etc especially clauses concerning what occurs when the capitalisation ends. It cant just go on. Much like say a bank bill. I have seen this used where the capitalised interest is a seperate loan and on a shorter term for repayment to that of the principal

Interest only (or 50% etc) may also be a wise consideration for the initial period.

 

I see, so for
1) the equity release that's in Homer's name, it can act as a LOC for the trust according to the loan agreement.
2) if trust needs 20k for say stamp duty, they would borrow 30k in the hopes that 10k will cover until rent is generated, or they keep borrowing more from Homer's account 'LOC'
3) Homer would be able to claim. Deduction as he would be receiving an income from the trust prior to trust generating rent.

4) how does the funding trail work-
Loan agreement formed, Homer simply transfers money from his offset to trust account as needed for expenses, as per agreement.
Trust pays back Homer into a separate account in Homer's name, Homer repays bank?

5) what about in the event that the trust holds borrowed funds over the EOFY, it wouldn't need to distribute this would it? Would there be something in the loan agreement stating otherwise?

 

1. Homer can lend with terms like a LOC. A limit with different draw down dates.
2. yes
3. Yes, subject to the terms of the agreement

4. It would depend on the situation, but that is one way
5. There would be no issue with a trust holding borrowed funds over the EOFY. You might be confused here.

Keep in mind that a trust isn't an entity and cannot borrow or enter into contracts. it will be the trustee that does this. The trustee should also be concerned about deductibility of itnerest with borrowed money taking detours and avoid contaminating the loans

 

I can't find this Paul. Have you got the right TR?

 

Yes wrong TR. TR 98/1 and para11 would be more applicable and read in the context of case decisions concerning constructive receipt as well as general priciples regarding "receipt of income"

 

Thank you very much for the helpful information Terry and Paul.

A couple of last questions if I may, talking with my agent next week but these seem to be more general

1) if the corporate trustee is also a beneficiary and normally receives the majority of the trust income distributions for tax reasons,
A) can the company simply use the income for trust purposes as its role as trustee, without the need to lend it back to the trust, as I've read the trust cannot enter loan agreements, it would be the trustee that does this, and it can't lend to itself,
B) is that correct?

2) can the above actually be achieved or would it require a separate 'bucket' company?

3) any other questions I should be asking my tax agent or lawyer?

EDIT: sorry Terry, just read some of your other posts about being a trustee and beneficiary is a bad idea.

 

A person cannot lend to itself so if the trust distributed to the trustee you would have a problem with the company lending it to the company as trustee.

Being a trustee and a beneficiary is not necessarily a bad idea. I set up many trusts this way.

 

Is the proposed loan agreement likely to pass the ATO's scrutiny? I had a client who did a loan agreement thru an online lawyer and the ATO, in a private ruling, considered it an agreement which would not make the onlending interest deductible - to either the individual or the trust.